Thursday, November 21, 2013

Investment and Retained Earnings

A simple empirical fact: in the decades before 2002 about 50% of US investment spending was financed by retained earnings, and about 50% by debt and new equity issues (Moore 2002: 147). Historically, investment from retained earnings was probably more important than in more recent times.

Business retained earnings – when not re-invested in real capital or other real assets – are often held in the form of financial assets, like stocks, shares, bonds, bank accounts (such as corporate demand deposits and savings accounts), or fixed term deposits. In other words, these are monetary savings. Yet these “savings” can be held over long periods of time before being drawn on.

A rise in business spending on these secondary financial assets (from their monetary profits) does not induce employment, and when this happens the corresponding fall in real capital investment is an important factor in recessions and periods of insufficient investment and high involuntary unemployment.

Furthermore, the importance of retained earnings is an even more important blow to the idea that investment is a simple function of interest rates: that is, the idea that a flexible interest rate that allegedly moves towards a Wicksellian natural rate can clear all capital goods markets.

9 comments:

"Business retained earnings are held in the form of financial assets, like stocks, shares, bonds, bank accounts (such as corporate demand deposits and savings accounts), or fixed term deposits. In other words, these are monetary savings. "

Not necessary.

Retained earning can be in the form of accumulation of fixed capital and not just accumulation of financial assets. It can even be in the form of negative incurrence of liabilities.

So a firm which ends up with retained earnings in an accounting period needn't see a rise in financial assets in the asset side of the balance sheet.

(1) retained earnings will be invested in capital goods and more capacity, which may well remain unused?

(2) retained earnings will be used as collateral for new loans?

I sure this happens too, but how prevalent is it? Is there empirical evidence for the extent of such practices?

But even with (2) assuming the money loans are not used on capital investment or hiring more workers, but for other purposes -- say, buying back the company's own stock to raise the price -- it follows that this spending it is not directly adding to AD.

"Actually the more interesting question is why firms hold financial assets at such a large scale!"

To obtain a return on money earned but not invested in real capital assets, and to deal with uncertainty via holding of liquid assets?

Also in B.102 "Balance Sheet of Nonfinancial Corporate Business" on p. 114the financial asset values reported are still high and non-financial assets values not greatly higher than financial asset values.

The point I am making is that you started out by saying historically investment was financed by retained earning (and incurring liabilities) which is right but then in the second para is contradictory to this!

I think a lot of people tend to think of NAFA as saving. For a firm, the flow of retained earning is its saving. But NAFA not = RE.

About your point on liquidity, there are many questions here: a firm doesn't need such high stock of financial assets. One may also ask why don't they pay higher dividends and so on.

"Business retained earnings – when not re-invested in real capital or other real assets – are often held in the form of financial assets, like stocks, shares, bonds, bank accounts (such as corporate demand deposits and savings accounts), or fixed term deposits. In other words, these are monetary savings. Yet these “savings” can be held over long periods of time before being drawn on. "

The question is what determines how much savings (retained earnings) are actually invested. Kalecki said that it was profitability -- i.e. the level of earnings, i.e. effective demand. That's not a perfect answer but its leading in the right direction.